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As a grandparent, you may feel that one of the most helpful things you can do to contribute to your grandchildren's future success is to contribute to their college education. In fact, according to Fidelity’s 2014 Grandparents and College Savings Study, 72% of grandparents think it’s important to help pay for their grandchildren’s college education, and more than half (53%) are currently contributing, or planning to help them save.1

But how and where should you begin saving? Also, what factors should you consider?

Which account is best?

When evaluating the best college savings option for you, it's important to consider your financial situation, your grandchildren's, and the financial situation of their parents. Also, consider the tax advantages of each type of account, on both the federal and state levels.

There are three main tax-advantaged college savings vehicles to consider:

The 529 college savings plan is by far the most popular of the three. It offers favorable financial aid treatment, tax advantages, and a great degree of flexibility and control for account holders. These savings plans are particularly attractive to grandparents who want to lower the value of their taxable estate.

Custodial accounts, either Uniform Gifts to Minors Act (UGMA) accounts or Uniform Transfers to Minors Acts (UTMA) accounts, offer more investment choices but may weigh more heavily on financial aid. They offer limited tax benefits in that a portion of earnings may be taxed at the child’s tax rate, and the money saved becomes the child’s at a certain age, regardless of whether they go on to college.

The Coverdell Education Savings Account (ESA) offers tax advantages similar those of the 529 plan, but has a $2,000 annual cap on contributions. Still, if you're contributing only $2,000 or less per year, these savings vehicles can be attractive, particularly because they offer a broad range of investment options. (Note: Fidelity does not offer Coverdell ESAs.)

We describe all three types of accounts below in detail, from the perspective of a grandparent. But before you choose one, consider the questions in the box to the right in the sections below.

Here's a more detailed look at each of these savings plans:

529 plans offer many benefits.

The 529 college savings plan offers several features, which can vary from state to state, but in general most 529 plans offer:

Tax advantages. Withdrawals from 529 college savings plans are federal income tax free when you use them for qualified higher education expenses. This includes tuition, books, fees, supplies, and other approved expenses at accredited institutions.

Control. When you open a 529 account with a grandchild as beneficiary, you maintain control of the account, which lets you decide when to disburse the proceeds; you can even decide to change the beneficiary if desired.2 Or, if the parent opens the 529 account, you can simply gift to that account and the parent maintains control.

Front-loading of college savings. Grandparents can front-load a 529 plan (giving five years' worth of annual gifts of up to $14,000 at once, for a total of up to $70,000 per grandparent, per beneficiary) without having to pay a gift tax or chipping away at the lifetime gift tax exclusion.3 This would allow more time for these savings to potentially grow tax deferred (see discussion below on gifting). It would also lower the value of your estate.

Minimal impact on financial aid. Because 529 college savings plans are considered parental assets, they are included in the Expected Family Contribution (EFC) calculation for federal financial aid, and count for up to 5.6% of assets (versus 20% for a student asset such as a UGMA/UTMA account).

One catch to consider for a grandparent’s 529 account. A 529 account held by a grandparent is treated differently for the purposes of student aid. The account balance isn’t included as an asset in the EFC calculation. However, once the money is distributed, it is considered student income. Student income can have a significant impact on financial aid. (See further discussion below.) "A gift from a grandparent is seen as an indication that there’s more income that the student could be using," says Keith Bernhardt, vice president of college planning at Fidelity Investments.

Investment options. A 529 plan offers a selection of investment options, often including age-based investment options that automatically become more conservative as the beneficiary approaches college age. However, the range of options is not as broad as those available in Coverdell ESAs or UTMA/UGMA brokerage accounts. For example, you cannot invest in individual stocks through a 529 plan.

Withdrawing money. You could withdraw the money yourself at any point. However, be prepared to pay income taxes on any earnings, plus a 10% penalty on those earnings if the money is not used for qualified higher education expenses.

UGMAs/UTMAs belong to the beneficiary.

A parent or grandparent can use a custodial account (UGMA/UTMA) to save for a child, but the child named on the account would gain control once he or she reaches a specified age. These accounts have pluses and minuses:

Loss of control. The custodian controls the account until the child reaches a specified age, typically 18 or 21 (rules vary by state). Once the account beneficiary reaches that age, he or she can use the money for anything. This might be a concern for people who fear that the beneficiary might spend the money unwisely or on noneducational items. On the flip side, giving the child control could prevent the parents from intervening in the account.

Modest tax benefits. The interest, dividends, and capital gains each year from the UTMA are reported under the child’s Social Security number. If the child is a minor (or full-time student under age 24), the first $1,000 earned in 2014 is tax exempt. The next $1,000 is taxed at the child’s tax rate, typically lower than the parents’. Any yearly earnings above $2,000 are taxed at the parents’ rate. However, all withdrawals face taxes on capital gains.

More flexible investment options. While the loss of control might be a disadvantage to many parents, the greater range of investment options in a custodial account versus a 529 plan could be attractive to a knowledgeable, self-directed investor.

Less student aid. Because custodial accounts—UGMA/UTMAs—are counted as a student’s asset, they are generally factored into the EFC at 20%, which is much higher than the 3%–5.6% factored in for parental assets. See the EFC calculation.

Coverdell ESAs offer tax-free savings but are limited.

Coverdell ESAs offer a tax-deferred and potentially tax-free savings option if used for college expenses or other education expenses from kindergarten through 12th grade. Withdrawals are tax free if used for qualified expenses for taxpayers who don't claim an American Opportunity credit or Lifetime Learning credit for the same expenses in the same year. Coverdell ESA benefits and disadvantages include:

More investment options. Coverdell ESAs have a greater range of investment options than 529 plans, and could be attractive to a knowledgeable, self-directed investor.

Lower contribution limit and possible confusion. Coverdell ESAs have a low annual contribution limit of $2,000. This is the total amount that all individuals can contribute to one account—or to multiple Coverdell accounts for the same beneficiary—in any year. Unless all family members know what others are contributing and how many accounts have been opened, it could be easy to make an excess contribution. In that case, the holder of the account would owe a penalty.

Income eligibility factor. The ability to contribute to a Coverdell ESA is phased out for single tax filers with modified adjusted gross income (MAGI) between $95,000 and $110,000 and for joint filers with MAGI of $190,000 to $220,000.

Loss of control for grandparents. Most ESAs require the child's parent or guardian to be responsible for the account. In losing control of the account, a grandparent would no longer have the option of transferring the money to a different beneficiary, or of withdrawing the money if needed for other purposes. That said, there is no law that prevents a grandparent from opening a Coverdell account—if he or she can be certain that no one else plans to open one or if the amount the grandparent is contributing would not interfere with the parent's contribution.

Important considerations on 529 plans

In many situations, a 529 account may prove to be an attractive education funding vehicle. However, there are some considerations that grandparents should take into account. For example, if financial aid is a concern, it would make sense to discuss options with the parents in order to come up with an appropriate plan. For example, it may help if the parents pitch in for the first few years of college and the grandparents help for the last year, after the final financial aid decisions are made.

One strategy is to wait until late in the student's junior year before withdrawing from a grandparent’s 529 college savings plan account. That way it wouldn't affect eligibility for aid even in the senior year. Alternatively, the grandparent could simply choose to not open a 529 account but instead give to the parents’ existing account if retaining control isn't important. Some grandparents just want to make a simple gift and have no ongoing involvement.

A major drawback to ownership of a 529 plan account for grandparents who aren’t that well off is the possible loss of Medicaid assistance. The 529 plan account balance would have to be spent on your care before Medicaid payments could begin.

Also, when it comes to estate taxes, one catch is that if you were to take advantage of the annual gift-tax exclusion and front-load five years’ worth of gifts to your grandchild, and you died during that five-year period, the contributions for any remaining years would be brought back into your estate.

"The 529 plans are particularly attractive as a savings option for younger children because of the front-loading option and the long-term market growth potential," says Ajay Sarkaria, a senior wealth planning specialist at Fidelity Investments. "They also offer you some flexibility if you own the account. In an emergency, you could withdraw the money, but you’d pay a penalty and taxes on the earnings." No other vehicle offers this combination of estate reduction while retaining access to the account.

Open a 529 plan in an UTMA.

Another approach for grandparents combines features of both custodial accounts and 529 college savings plans: opening a 529 college savings plan within a UTMA. By placing a 529 plan within a custodial account for which the grandparent is custodian, the grandparent can retain control until the student becomes of age (generally 18 to 21, but varies by state). After that, the student would have control, but must use the money for college expenses or pay a penalty.

"This would allow you to receive tax-deferred growth and spend the money tax free on college expenses, plus it would ensure that the student receives the money no matter what," Bernhardt says. That would protect against the risk that a parent might withdraw money from a child’s 529 plan and spend it on something else. Consider a scenario where the grandparent contributed generously to a 529 plan account owned by a parent, who then withdrew the money for his or her personal needs, willingly paying a 10% penalty plus taxes on any earnings. In brief, it comes down to trust, and one's desire for flexibility and control.

Family members can benefit greatly from working together. "Consider the student’s financial aid picture," Bernhardt says. "It’s good to have an open dialogue and coordinate closely with the child and the parent."

Another option: Pay for college directly.

An estate-planning advantage of paying directly is that the direct payment is not considered a gift to your grandchild, which means that you can also make an annual exclusion gift to the same grandchild. However, this approach could sharply limit financial aid eligibility, because direct payment of tuition by a grandparent could reduce subsequent financial aid dollar for dollar.4 Also, while paying tuition directly will not be considered a taxable gift, you would still not have the years of tax-advantaged savings that you would have with a 529 plan or a Coverdell ESA.

Under certain conditions, a Roth IRA might be an attractive and flexible account type for accumulating education funding assets. You should speak with your accountant or your financial advisor for guidance on your particular situation.

It's never too late.

"It's never too late for grandparents to help with their grandchildren's college expenses," Sarkaria says. "While 529 plans might be ideal for younger grandchildren, you always have the option to pay directly for college tuition expenses once they are in college."

Whatever you do, begin by understanding all your options, and think them through carefully.

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Please carefully consider the plan's investment objectives, risks, charges, and expenses before investing. Contact Fidelity for this and other information on any 529 college savings plan managed by Fidelity, call or write to Fidelity for a free Fact Kit, or view one online. Read it carefully before you invest.

3. In order for an accelerated transfer to a 529 plan (for a given beneficiary) of $70,000 (or $140,000 combined for spouses who gift split) to result in no federal transfer tax and no use of any portion of the applicable federal transfer tax exemption and/or credit amounts, no further annual exclusion gifts and/or generation-skipping transfers to the same beneficiary may be made over the five-year period, and the transfer must be reported as a series of five equal annual transfers on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. If the donor dies within the five-year period, a portion of the transferred amount will be included in the donor's estate for estate tax purposes.

4. Savingforcollege.com, College Savings 101, "For grandparents."

The UNIQUE College Investing Plan, U.Fund College Investing Plan, Delaware College Investment Plan, and Fidelity Arizona College Savings Plan are offered by the state of New Hampshire, MEFA, the state of Delaware, and the Arizona Commission for Postsecondary Education, respectively, and managed by Fidelity Investments. If you or the designated beneficiary is not a New Hampshire, Massachusetts, Delaware, or Arizona, resident, you may want to consider, before investing, whether your state or the designated beneficiary's home state offers its residents a plan with alternate state tax advantages or other benefits.

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